The muni market—and BABs in particular—roared back in the first quarter, but can that last?
This blog is the first in a series of quarterly reviews on the state of the fixed-income ETF market. Each will focus on one fixed-income ETF category as defined by ETF.com’s ETF Classification System methodology and provide an overview of the state of the category and performance comparisons. The best-performing ETF from the best-performing focus/niche will be selected for further analysis of performance drivers.
The municipal bond market, driven by improvement in fiscal conditions in many localities, record-low issuance at a time of strong investor demand for tax-free bonds, and a somewhat benign interest-rate outlook, rose sharply in the first quarter, reversing what had been a pretty dismal 2013.
The Barclays Muni Bond Index is up 3.23 percent so far this year, outperforming the Barclays US Aggregate Bond Index by about 140 basis points. Even more impressive is the Build America Bonds (BABs) pocket of munis, one of the biggest losers in 2013, which is up this year three times as much as the Barclays Agg.
I’m going to explore some of the structural drivers and macro factors that affect BABs and related ETFs. The economy is improving but, it seems, in fits and starts. That means that while rates are moving higher toward historical norms, the exact path and time horizon are anything but certain. In my view, rates are likely to move up gradually and unevenly across the yield curve with significant volatility.
Translation? Investors looking for a smooth ride may not have the stomach for munis.
In other words, because muni bonds have longer maturities and durations in general, the prospect of rising interest rates hits munis harder than other parts of the bond market. Specifically, the Barclays Muni Bond Index fell 3.1 percent last year, while the Barclays US Aggregate Bond Index lost 1.8 percent.
Remember that the muni market fell apart last year after former Federal Reserve’s Chairman Ben Bernanke whispered his now-famous remarks about the need to begin “tapering” five years of quantitative easing
Nowhere is muni duration risk—or duration advantage—of relatively long-dated munis more clear than in the BABs pocket of the muni market. The Barclays US Aggregate Build America Bond Index fell 5.8 percent last year, and this year is outperforming both the Barclays Agg and Barclays Muni Index on the way back up, as the two charts below show.
Let’s take a step back for a moment to define what exactly BABs are and how their unique market structure works.
Created after the financial crisis when many localities were having difficulties securing financing at reasonable costs, the BABS program subsidized localities to help them reduce their borrowing costs for various “shovel-ready” infrastructure projects.
There are two types of BABs—tax credit; and direct payment. The direct payment BABs provide federal subsidies on the interest expenses to the issuer. The tax credit BABs provide tax credit directly to bondholders.
BABs differ from conventional muni bonds in one key way: callability, which is to say, most BABs aren’t callable.
Convexity measures the sensitivity of duration to changes in interest rates. With embedded callability options, many conventional muni bonds have lower convexities, and even negative convexities—prices drop when benchmark yields drop—at times in the low-yield area of the diagram below. It’s intuitive that issuers might call away bonds with higher coupons and issue new bonds at a lower rate.
The price of a bond with a call option and negative convexity might actually drop when yields drop, because investors expect the issuer might simply call away the bond.
BABs Not Callable
Unlike conventional muni bonds, most BABs are not callable, resulting in higher convexities.
Bonds with higher convexities will react more violently to interest-rate changes in a low-rate environment, while the opposite is true for bonds with lower convexities in a high-rate environment. Given the current ultra-low-rate environment, bonds with high convexities will see wider price swings——up or down—as interest rates change.
BABs with the same duration but greater convexity than their callable muni counterparts will be more sensitive to interest-rate changes. This explains why BABs performed so poorly in 2013 as yields on benchmark 10-year Treasury notes rose somewhat sharply after Bernanke’s tapering comments.
As benchmark yields retreated in early 2014, things began to look very different for muni bonds and for BABs.
There are three BABs ETFs on the market. They are the SPDR Nuveen Barclays Capital Build America Bond ETF (BABS | C-99), the PowerShares Build America Bond Portfolio ETF (BAB | B-61) and the actively managed Pimco Build America Bond Strategy Fund (BABZ | B-69).
All three funds have returns in excess of 5 percent thus far this year, which is as impressive as muni returns go. SPDR’s BABS, in particular, has returned more than 6.9 percent.
So what exactly has been driving the solid returns in excess to the broad muni market?
It’s a combination of duration and convexity, and investors’ continuous hunt for yield, according to Patrick Smith, chief investment officer of Granite Springs Asset Management.
Duration And Convexity: A Catch-22
As I pointed out, munis generally have longer maturities and durations than many other bonds, and because of that, they are more sensitive to interest-rate changes. Again, as Treasury yields started to rise in May 2013, the muni market took a big hit, and the BABs market was hit even harder.
But it is, as I said, a different story so far this year. Benchmark 10-year Treasury yields have retreated from their post-financial-crisis high of more than 3 percent in December 2013 to about 2.7 percent.
This drop in benchmark yields has benefited portfolios with longer durations and higher convexity. So it’s no surprise that BABS, with their longer durations, outperformed their shorter-duration peers and the broad U.S. investment-grade bond market.
The following portfolio attribution analysis clearly shows that much—almost half of BABS’s total return, or 341 basis points, has come from changes to the yield curve, depicted at “YC” in the table below.
|Performance And Attribution Comparison|
|Ticker||Total Return||Price Return||Total YC Return||YC Change||YC Carry||TC Convexity||Modified Duration||Convexity (Opt Adj)|
Data source: Bloomberg (as of 3/31/2014)
When Treasury yields didn’t rise as much and as fast as some have anticipated, it resulted in a “snap back” in performance in munis and to BAB portfolios, according to Smith.
Of course, all this comes with a note of caution: When interest rates and Treasury yields again start moving higher, BABs—and BABS in particular—will again take a big hit because their longer durations make them sensitive to changes in yields and the interest-rate outlook.
The Never-Ending Quest For Yields
Smith also pointed out that muni bonds—BABs in particular—are carrying higher yields.
As investors continue to hunt for yields in this ultra-low-rate environment, BABs look rather attractive for those looking for steady income streams. All three BABs funds have yields to maturity (see the YTM column in the table below) of more than 4.5 percent, which is quite attractive relative to broad munis or U.S. agg funds.
|Performance And Attribution Comparison|
|Ticker||Total Return||Income Return||Coupon||YTM||Current Yield|
Data source: Bloomberg (as of 3/31/2014)
Bottom line: Driven by significant improvement in fiscal condition across many localities, record-low new issuance and limited supply, as well as strong investor demand for tax-free bonds, the muni market has seen a broad rally in the first quarter of 2014.
Having even longer durations and higher yields, BABs—and the ETF “BABS” in particular— have benefited as yields retreated from post-crisis highs and investors’ continuous quest for yields.
But as I said, as interest rates resume their upward path toward historical norms, it will be difficult for munis and BABs to repeat their recent impressive performances.
Afterthoughts: Since the federal government has discounted the BAB program, no new issues will come to market. Smith believes BABs funds will eventually turn into target-date funds and will gradually unwind as underlying bonds mature.
Stay tuned for the next blog in the series on the U.S. government category. There was a surprising outperformer.
At the time this article was written, the author held no positions in the securities mentioned. Contact Howard Lee at [email protected].